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Does The Bond Market Know Something The Stock Market Doesn’t?
While everyone is looking at the stock market, the bond market has something to say. And, what it is saying may be very important in determining what the stock market does from here forward.
Spread ‘em
As a review, the “10-2 spread” is the difference between the yield on 10-year U.S. Treasury Bonds and 2-year U.S. Treasury Notes. The idea is that in “normal” times (remember those?), the bond that you hold for a longer time period (the 10-year) will yield more than the 2-year bond. After all, more can go wrong over those additional 8 years. You want to be compensated for that.
However, at times of economic stress, typically late in an economic cycle, the 10-year yield may fall below the 2-year. This is called an “inverted yield curve.” Inversion, followed by a return to a normal shaped yield curve (”reversion”) typically forecasts a recession.
The reversion version
Late last August, the 10-2 spread did invert, for a few days. Then, it moved slightly positive (i.e. it reverted). To those of us who have lived through some market cycles, this started a clock. The countdown to the next recession was on. We got it this year, right on schedule.
However, the story does not end there. When the yield curve returns to its normal, upward-sloping pattern after an inversion, a bear market is typically not far away. True to form, we plunged into an official bear market earlier this year.
Hey bond market: no secrets please!
Sure, there has been an historic bounce from the March lows. However, the current concern relates to the risk level of the stock market from here. In other words, is the bond market telling us something that the stock market does not know yet? That is the whole point of analyzing the 10-2 spread.
The charts below show us why.
Lather, rinse, repeat
The chart above shows a history of 10-2 inversions and re-versions going back to the late 1970s. To cut through the clutter of the chart, here is the process: 10-2 spread goes negative, then reverts to normal, recession hits, stock market falls. Every recession in the last 40 years has played out this way.
The chart below zeroes in on a typical example of this. This is the Global Financial Crisis edition, 2007-2008. What I charted for you is what happened AFTER the re-version of the 10-2 spread lifted that spread to about the level it is now (the 10-year yields about a half-percent more than the 2-year).
The question I asked myself in writing this article was whether we just saw the bear market, and it’s over, or if it was just the first round. As frequent readers of this blog know, I am not a bull or a bear. I am a realist. I look at all of this stuff with an open mind.
What’s next?
Investing is not guessing. It is sizing up the reward potential, and comparing it to the risk of major loss in pursuing that reward.
So, what happened from this point in 2007? The S&P 500 fell by 48% in less than 18 months, through 2008 and into early 2009. Will it happen like that again?
Of course neither you nor I know the answer to that question. But in terms of investment strategy, here are my conclusions:
- The risk many investors are taking to earn returns in the stock market is historically very high. It has been that way for over 2 years.
- The bond market is signaling that long-term interest rates are headed higher. Maybe not immediately, but eventually. That usually coincides with an uptick in inflation. After years of subdued consumer prices, even a modest lift in that could be a rude awakening for retirees and pre-retirees.
- Don’t take ANYTHING for granted in this environment. Have a plan.
- Keep watching the 10-2 spread for additional cues about bond and stock market risk.
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